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By Scott Burns | 12-22-2010 10:55 AM

Gain Muni Bond Liquidity With ETFs

Morningstar's Scott Burns and Tim Strauts explore how ETFs can provide individual investors with greater liquidity than owning individual bonds.

Scott Burns: Surveying the municipal bond ETF landscape.

Hi, there. I'm Scott Burns, Morningstar's director of ETF research. Joining me today is Tim Strauts, our fixed-income ETF analyst.

Tim, thanks for joining me.

Timothy Strauts: Thank you.

Burns: So, the municipal market and municipal bond ETFs have seen a lot of volatility lately, a lot of discount activity, but before we start talking about the ETFs, let's just talk about the muni bond market a little bit.

We've seen some negative returns and a lot of volatility. What's been the primary cause of that in the municipal space?

Strauts: The primary reason for the volatility is basically the Nov. 3 Fed meeting, where the Federal Reserve came out and said that they were going to enact a second round of quantitative easing. Well, since that announcement, all fixed income, not just municipals, has basically traded down. The 10-year Treasury went from about 2.6% on Nov. 3 to today about 3.3% ...

Burns: ... On a yield basis ...

Strauts: On a yield basis.

Burns: As yields go up, prices go down.

Strauts: Yes. So the yields have gone up, price has gone down. So that affects munis, too, because munis are priced off of Treasuries. So, most of the move has been because of that. Now, I will say, though, that the municipal bond space was sort of weakening, maybe not really trading down, but just weakening for a month or two before [the announcement]. So on average the muni bond space has traded down further than Treasuries, but mostly it's because of the recent Fed announcement.

Burns: Right, and so we see this increased--almost leverage--on Treasury interest rates for municipal bonds. What's usually the source of that...?

Strauts: What you are going to see is that, typically speaking, in a normal environment, the municipal bond yield should actually be a little bit lower than Treasuries, because you are getting a tax-free yield, assuming you are an individual investor who can get the tax-free benefits. So the yield should be a little bit lower. But recently, actually, the yield has been higher than Treasuries, just because of the increased credit-quality concerns.

Burns: To step away from muni bonds, specifically tax-free muni bonds, let's talk about their cousins, Build America bonds. In the tax package, they did not extend that program this year. What is that going to mean for Build America Bonds and Build America Bond investors, and also for traditional municipal bond investors?

Strauts: Municipal bond investors are going to have a really big impact, because Build America Bonds had taken up about 20% of municipal issuance in the last two years.

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